Ahead of the Curve

The lending environment is undergoing a worrying change. Funds that European direct lenders have raised but not yet deployed are at an all-time high and banks in most Western-European jurisdictions have renewed lending following years of reticence after the global financial crisis, leading to increased competition amongst lenders in the small and medium enterprise (SME) market.

Mitigating Risk in Transition Management

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In the days before the perfect storm — a convergence of near-zero interest rates, extreme volatility, evaporating asset values and a market blinded by fear — the business of global transition management was relatively straightforward. When markets were sanguine, institutional investors generally remained within the same asset class, even when they shifted portfolios from one manager to another.

But in the last 18 months, institutions with ongoing funding commitments such as pension funds suddenly found themselves with liabilities exceeding eroding assets. “Pension funds’ funding capability fell from 100% to 75%, so they needed to reallocate their portfolios to increase returns and decrease volatility. But many pension funds had to hold off implementing the new allocations, due to a combination of market turbulence leading to uncertainty and because transaction costs can be high during times of unprecedented volatility,” says Kal Bassily, head of global transition management at ConvergEx.

Indeed, the CBOE Volatility Index (VIX) surged to almost 90 points in October 2008, the highest since the VIX debuted in 1993. As of early September 2009, the index had returned to about 26 points, which is slightly higher than January 2008 levels.

In this milieu, “we as transition managers had to change the way we worked. The focus is risk management. Now, we spend about half of our time planning how to manage risk,” Bassily says. The main risk categories in a transition context are operational risk, execution risk and investment risk. Each one of these risks can be managed using different techniques and strategies.

Execution risk has been among the most crucial perils in a startled market. Bassily’s team at ConvergEx circumvented liquidity risk by minimising open-market trading and seeking “dark liquidity”, which exists outside of open markets and is not displayed on central trading books. These liquidity pools can sometimes be found in the electronic communication network (ECN), which eliminates the market maker or other middleman by directly linking traders and brokerages.

It also became necessary to hedge more often than before. “Some trades take several days, sometimes weeks, to execute and a volatile market can move against the client during that interim,” Bassily says. Hedging instruments include index options, index futures, exchange-traded funds, and other instruments.

Impeccable execution has also been important because a split-second delay in a volatile market may make the difference between profit and loss. Here, a transition manager with in-house execution capabilities might have an advantage. Without the need to outsource trading to a third-party broker, execution risk, an extra layer of fees and information leakage can be reduced.

In Asia, imperfect execution and post-trade processing can be more costly than in Europe or the US, says Alister van Bergen, ConvergEx’s vice president overseeing the global transition management service in Asia. “The cost of overdrafts and settlement failures can be significantly higher in Asia, for example,” van Bergen explains.

Moreover, the lack of standardised clearing, settlement and messaging systems throughout Asia increases transaction costs, in some instances by about 30% more, according to some studies.

Not all global transition managers, however, have in-house execution capabilities across all asset classes. ConvergEx is one of the few pure agency transition managers that does. The firm was established in 2006 from a combination of the Bank of New York’s execution businesses and Eze Castle Software. Today, ConvergEx remains an agency broker, which means it is obligated to fill clients’ orders at the best possible price at the greatest speed possible. In May, ConvergEx scored highest for its execution services in the 2009 Transition Management Survey by Plansponsor magazine.

Besides unprecedented market events, there are other complexities. Many institutional investors’ portfolios and relationships with asset managers have gained intricacy in recent years.

“Over the last 18 months, pension funds have had more complex transitions. For example, they may have multi-manager relationships, with various underlying levels of pooled funds. We need to keep track of the daily net asset value calculations and the multiple layers of fees in each relationship,” Bassily says.

Bassily and van Bergen notice two major trends emerging from institutions’ battle to preserve capital: First, clients are exiting low-quality fixed-income assets in favour of higher-quality fixed-income instruments. Second, Asian clients’ cross-border investment activity were frozen at the height of market volatility, but they are returning to the cross-border markets now.

Van Bergen says: “Some Asian market centres are very sophisticated, but in others, offshore investing is new and many institutions are just beginning the process of using external service providers such as custodians, external asset managers and transition managers, so they are coming in at a different point of the investment lifecycle.”